Deep Dive

It's the Politics, Stupid

The eurozone crisis isn't about debt or deficits -- it's about a dysfunctional political system.

Europe is not suffering from a debt crisis. It is, rather, a political crisis. With the arguable exception of Greece, the EU countries under attack by financial markets are basically strong, wealthy, and productive. Yet from the early tepid responses when the crisis started in Greece two years ago to the most recent agreement German Chancellor Angela Merkel forced on EU member states, European leaders have been shockingly unwilling to face up to the political facts. The treaty revisions outlined during last week's summit focus solely on debt and do little to address the underlying political uncertainty that is driving the financial contagion at the heart of the crisis.

Indeed, the restrictive straitjacket of fiscal orthodoxy agreed to at the Brussels summit on Dec. 9 is only likely to hasten the demise of the euro, not save it. Enshrining deficit and debt rules in treaty language will not deter international bond markets from charging unsustainably high rates to EU states attempting to borrow money. Nor is it the right medicine for European polities under stress, which need to grow their way out of debt, not strangle their economies with ludicrous public finance rules. EU leaders, and Merkel in particular, need to demonstrate commitment to a true political and fiscal union that offers support, not just sanctions, for its members. Only by pooling together the strength of the eurozone in a collective debt instrument while offering a process of real decision-making over the direction of the European economy will the monetary union survive. Technocratic pleas for fiscal restraint fundamentally misunderstand markets, the nature of the problem, and its solution. Financial contagion is about beliefs, perceptions, and testing political will, and markets are not likely to buy what Merkel -- and the member states who must follow her dictates -- are selling.

So what is really going on in Europe? Is it really about debt? No. Debt and deficit figures diverge widely across the European Union and indeed across the industrialized world, yet debt levels do not reliably track with the amount bond markets charge sovereign borrowers in Europe or elsewhere. Debt-to-GDP ratios, as recorded by the IMF, vary from 87 percent (France) to 67 percent (Spain) to 121 percent (Italy), yet all these European states are being charged rates above what states like Germany (83 percent), the United States (100 percent), or Japan (an astounding 233 percent) are charged. The IMF estimates that Japan's debt will reach 250 percent of GDP in 2015. By comparison, the IMF forecasts that Greece's debt-to-GDP ratio in 2015 will be 165 percent, Italy's 116 percent, and Spain's 76 percent. Yet no one is talking about Japan's bond-financing problems. The bottom line? Arguing that Europeans need to "live within their means" is nonsense in a world where there is flexibility in how markets perceive what appropriate debt levels mean.

Perhaps debt matters because of another economic factor. Is the problem that European countries are simply too economically divergent to be in a currency union, making investors more worried about debt in the eurozone than in national settings? Once again, the evidence does not support this facile answer. Currencies are, without historical exception, determined by national borders -- by politics -- not convergent economic zones. The United States is a case in point. From a purely economic standpoint, it should not have a single currency, as regional economic cycles across the United States inevitably give rise to different fiscal and monetary needs despite the Federal Reserve's one-size-fits-all monetary and exchange-rate policy. Scholarship examining the optimum geographic areas for single currencies suggests that the United States should have several currencies -- a Pacific Northwest dollar area, a Sun Belt dollar, a Midwest industrial dollar, and a Northeast dollar. Yet no one worries about the breakup of the greenback because of this.

The reason? Political unity. The United States survives its uneven regional economic cycles because it has a true fiscal and political union. Treasury bonds pool risk at the national level while automatic stabilizers dispense funds where needed in hard-hit areas and bring in revenues from booming areas where times are good. Through the current crisis, America's stability as a unified political entity has never been in doubt, sending confidence and certainly to markets despite the wrenching effects of the Great Recession.

Instead of recognizing the importance of political commitment and political mechanisms in stabilizing monetary unions, however, those interested in austerity are using the crisis to shore up their own agendas, with seeming disregard for the consequences.

While last week's agreement was framed by Merkel and French President Nicolas Sarkozy as the basis for a fiscal union, the system established bears no resemblance to any functioning fiscal union in history. Governing solely by rules and sanctions, imagining that national polities will somehow adhere to the goals of keeping public debt at 60 percent of GDP and budget deficits at 3 percent of GDP is fundamentally at odds with everything we know about how politics work in real life and smacks of magical thinking. The agreement is a rewarmed version of the existing Stability and Growth Pact (SGP), based on guidelines set down two decades ago when European leaders decided to move forward with the euro.

Let's recall that Germany and France both eventually violated the SGP (as they should have) when their economies needed a boost. Romano Prodi famously called the pact "stupid" when he was president of the European Commission, and economic theory has never found a rationale for the specific target numbers. What's needed is not the automatic application of mindless rules meant to be broken, but rather the discretion to decide what is right in any given situation, determined collectively by democratically elected EU leaders within the governance institutions of a real fiscal union.

Single currencies have historically been forged in war as part of larger state-building projects that wrestled power to the center through taxing, spending, and debt instruments grasped by leaders in search of the tools to survive in the face of military conflict. The European Union has been an exception, but its time may be up. As politically difficult as it may be for Merkel to recognize the need to pool sovereignty by agreeing to a Eurobond and true fiscal union, it is myopic at best for her to destroy the considerable economic and political benefits that Germany has gleaned from the euro and the broader EU project. If austerity and nonsensical rules on deficits and debts in a faux fiscal union are the only way forward for the eurozone, we should all prepare for its demise.


Deep Dive

A Bridge to Nowhere

The Brussels plan is a decent stopgap. But if Europe's countries in crisis can't hold out long enough to start growing their economies again, it won't matter.

The task of officials at last week's EU summit in Brussels can be likened to building a bridge. The fiscal and structural adjustments required of Europe's heavily indebted economies will take time to complete. Time will be needed in Italy to get parliamentary agreement on new taxes and even more time to begin collecting them. Rooting out tax evasion and privatizing public enterprise in Greece will take time. Whether pro-growth reforms actually succeed in producing growth similarly will take time to tell.

The problem is that the indebted and struggling European-periphery governments will not be able to fund their operations without official support in the meantime. With the outcome of the policy process uncertain, investors prefer to wait before buying bonds. They want to see not just good intentions but also good results.

So the crisis countries need help to get from here to there. They need the European Central Bank (ECB), the European Financial Stability Facility, the European Stability Mechanism, and IMF, in some combination, to step up and finance their governments while the requisite reforms are put in place.

The subtext of last week's negotiations concerned the terms on which this official support will be provided. The implicit question was whether the European Commission, the ECB, or the IMF would negotiate the conditions attached to the loans. The focus on legal reforms designed to strengthen fiscal discipline by giving the European Commission and the European Court of Justice roles in overseeing the fiscal conduct of member states was designed to make official creditors more comfortable about opening their pocketbooks.

Many details remain to be worked out, to make an understatement. But the outlines of the bridge can now be discerned. There will be strengthened fiscal rules and enforcement, whether through national legislation as a balanced-budget law or protocols to existing agreements. Consolidation and structural reform will proceed. And with governments doing their part, the ECB and its partners will provide the bridge finance needed to fund governments in the meantime.

But the danger is that the European Union and the international community are building a bridge to nowhere. Fiscal consolidation is needed, no doubt. Structural reform is well and good. Emergency financing is necessary to buy time. But none of this actually ensures the resumption of economic growth. And without growth there is no way that the eurozone crisis countries can make it to the other side.

It's a vicious cycle: Without growth, fiscal progress will be slower than promised. If economies stagnate, revenues will inevitably stagnate. Without growth, public support for policies of austerity will dissipate. And if pro-reform governments fall, there is no knowing what kind of governments will come next.

In addition to growing, Europe will have to rebalance internally. While the current account of the eurozone as a whole is roughly balanced, the Southern European countries are running chronic current account deficits with their northern neighbors. In some cases, like Portugal, it was the private sector that consumed more than it produced and became heavily indebted; in others, like Greece, it was mainly the public sector. Either way, now that debts have grown to unsustainable levels, rebalancing must take place. This will require not just slower growth of demand and spending in Southern Europe but concomitantly faster growth of demand and spending in Northern Europe. If Southern Europe is now to produce more than it consumes, then someone else has to do the opposite.

The solution is straightforward in principle. First, fiscal stimulus in Northern Europe. German politicians may be loath to transfer resources to spendthrift southerners, but why not transfer them to their own households through tax cuts? More household spending in Northern Europe is essential if there is to be intra-European rebalancing. Second, rates of fixed investment in Germany are strikingly low. A targeted investment tax credit would address this internal economic weakness while stimulating the demand for traded goods. Germany's demographics point to the need for fiscal consolidation at some point, but not now when demand across Europe is collapsing.

Stronger demand from the rest of the world can also help Southern Europe rebalance. A weaker euro that prices European goods into international markets would make it easier for the crisis countries to export their way out of their bind. Although the ECB's recent rate cuts are a step in the right direction, additional rate cuts and U.S.-style quantitative easing that push the euro down on the foreign exchange market will be essential if Europe is to grow.

The financial bridge tentatively agreed to last week buys time to put in place a lasting solution. But a bridge makes sense only if there is something on the other side.